We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Wednesday, November 12, 2008

Hank... Hank... you've got to be kidding me. Its clear to you that buying illiquid mortgages "is not the most effective" way to use the TARP. Seriously. Can some one please let Secretary Paulson know that mortgages are, in fact, the crux of the problem. Why do we have a problem with banks lending to each other? Because no one trusts anyone else's balance sheet. Because the mark-to-market price of mortgage assets just keeps falling.

Let's talk about the reality here. This doesn't represent a shift in strategy by Paulson. Banks have forced his hand.

There was whispers for a week or two that banks didn't want to participate in the TARP asset purchases. As individuals, they can't see the incentive. Its a classic free-rider problem. All banks would benefit if all banks participated, but each bank looking at its own situation individually isn't incented. Or more accurately, it isn't clear whether a bank would benefit individually or not, and given all the strings attached to participation in the TARP, banks are passing.

So where does this leave us? Worse. Undoubtedly worse.

We'll still get through this, but now you have to figure that home prices will bottom well in advance of the general economy. Why? Consider a possible progression:

1) Home prices bottom. Put whatever time frame on this that you'd like. I actually think it could happen sooner than many expect, but I digress.

2) Home lending is relatively robust for borrowers with good credit (It must be, or home prices wouldn't have bottomed!), but this is solely because the GSEs are there to securitize these loans. If the government is actively supporting the ABS markets, then credit card, auto and student lending markets will be performing OK as well.

3) But actual bank capital will remain challenged. By the time home prices bottom, banks will have taken more losses on foreclosures and commercial loans. And beyond the TARP, most banks will not have been able to raise significant outside equity capital.

4) So commercial lending will become very rare indeed until such time as banks have rebuilt their capital base. Therefore new business formation, acquisitions, capital projects, all will become difficult if not impossible.

What kind of economy does that leave us with? A long recession that's what. Recessions are caused by misallocated economic resources. Some businesses need to downsize or be eliminated, and those resources need to be allocated elsewhere. The recession is the pain that occurs in between.

But resource reallocation takes capital. And if banks won't lend, its going to take a long time indeed for that reallocation to occur.

11 comments:

We are in a liquidity trap situation. No matter what the Fed/Treasury does, banks will not lend. No matter how healthy their balance sheet becomes, they will not lend. They just are not behaving in a rational way right now and won't be for a while. So the Fed must find other ways to get money to consumers and companies that do not involve the now-PTSDed banks.

The Minneapolis Fed has published a study that refutes four claims about the way that the financial crisis is affecting the economy, namely, that banks aren't lending to non-banks, that banks aren't lending to banks, and that commercial paper volume has contracted. Here are the exact points they say are myths:

The way I look at it, the "bad assets" come in two flavors. Vanilla and Rocky Road -- or rather ordinary LOANS, and CDO and other asset backed securities. There has never been much problem with the valuation of regular loans -- it is transparent -- people have been doing it forever, and the valuation parameters are relatively tight. If someone is paying, then it is probably OK. If they aren't, then it is probably worth 50 cents on the dollar. Or something like that.

The residue of structured finance, on the other hand, is inherently opaque. There are clearly tranches of CDO's and other asset backed securities that are going to pay out. However, there is not much of a market for any of them. The only people that really understand them already own too many and don't have any money left to invest.

Those are the assets that need to be quarantined.

I don't know who owns them other then the largest banks and investment banks. Community banks were "disintermediated" out of the entire mortgage business. Most regionals, also.

The big banks have now been bailed out, via direct capital infusion. Wells Fargo is going to write off $60 billion in Wachovia mortgages as part of the acquisition, aided by the $10 billion or whatever they got from fed.

I think the banks will lend, but only on more difficult/expensive terms. If you have solid credit, then you can get money. However, the banks have gone from overly lax to overly conservative. I am talking about regular banks, not inter bank lending. I have no idea how that works and even why it is important, but will take on faith that it is a big deal.

I don't really see much difference between giving the banks capital via preferred stock and making a market in illiquid securities at above market price but below the ultimate value. I'm sure that there is a gap between the illiquid market prices and the ultimate value, but it is a tough one to try to estimate.

But back to regular banks. There regular loans aren't market to market, but it doesn't seem to bother anyone too much. They have loan loss reserves that even they admit will need to be raised. However, they are transparent enough that I don't see why getting them off someone's books matters much.

As far as getting people to spend -- you don't want to lend money to the same deadbeats that can't pay off their current debts. People with good credit are generally not tempted to load up on debt. The only thing I can think of is to bail out Detroit by offering leases on their cars that are effectively subsidized by the TARP, by lending to the auto finance arms on overly generous terms. I don't see much of a future for the domestic auto makers, but maybe now isn't the time to let them fold up. However, giving overly generous lease terms on US autos to people with less then perfect credit seems not so bad. They would rather buy a Toyota or Honda, and the finance guys would rather lease to people with 750 credit scores.

I don't really know who is having trouble borrowing. I asked my bank assistant manager -- and she said they haven't done anything. Except no more HELOCS on second homes, and a few other things. So the problems (as always in economics) are at the margins.

I don't disagree that a well executed asset repurchase program by the TARP would be better than the direct capital infusions. The uncertainty of future MTM losses would be removed. However, I do think it would have been much harder to implement quickly in a way that wasn't open to gross manipulation by the banks. The information asymmetry between buyer and seller in this program would ensure that the government buys the absolute worst assets at prices that are likely to be higher than eventual recovery.

I don't think either program will prevent the return to fundamentally responsible lending standards. With the possible exception of the very worst markets, I'm willing to bet that anyone who can put 20% down can easily get a mortgage at a good rate. That probably sounds draconian to many people, but that's how mortgages used to work!!

Banks are taking the capital infusions and using it to rebuild their balance sheets which is the responsible thing to do. If the government wants to artificially prop up house (and other asset) prices, they should do away with the pretense of a free market solution.

Is it possible the US-T realized the problem is far worse than thought? That perhaps the assets are worthless, in particular synthetic CDOs? And if they start buying them at even something above distressed prices, mark to market accounting would cause a complete collapse of the financial system?

This may be a stale thread, but your analysis is missing one huge point. It isn't the mortgages at the root of the problem. The root of the problem is that worldwide bank and credit standards went to hell. The evidence of this is that trader at SocGen with the huge loss that was all the news at the beginning of the year. I know enough risk management that I called BS on the idea that he did anything huge and sophisticated right at the outset, and the further reporting proved me right. The initial news was all you needed to see that SocGen wasn't doing proper deal confirmation.

This proved that even the big French banks, so proud of actually understanding Basle II and of having the highest standards in the world, failed on a risk management level that was not even risk management 101. They failed in the first chapter of the preread materials for the class.

Prior to the start of the year, it was well known that the asian banks had zombie loans and all that garbage on their books, and were still basically a mess (China and Japan particularly). The start of the year proved that bank standards worldwide had seriously degraded.

Now, I am not sure either that the banks forced Paulson's hand, in that I think he is running his shop for wall street from the perspective of Goldman. He just needs to go, quickly. The senate needs to suspend the party on the afternoon of Jan 20 and hold confirmation hearings for whoever Obama names (my personal favorite, Laura Tyson, second Alice Rivlin, though she is getting up there in years at this point).

How do we rebuild trust in the balance sheet? I guess I am coming around to the original idea of buying up the mortgages, though I still think the best reason for that is that eventually someone in the new administration would figure out that the thing to do is to restructure them (comment made before the election even, since I think McCain would have replaced Paulson even if he had pulled out victory). However, to rebuild trust also the banks are going to have to submit to a lot stricter oversight than they have seen in years.

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I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.